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Selected Provisions of the Fifth Protocol to the U.S.-Canada Income Tax Treaty

By Rafael Carsalade, CPA, PKF Texas, Houston, TX

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Editor: Kevin F. Reilly, J.D., CPA

On
September 21, 2007, the United States and Canada signed
the Fifth Protocol to the 1980 U.S.-Canada Income Tax
Treaty, which was the result of nearly ten years of
negotiations between the two countries. The changes to the
treaty resulting from this new protocol are numerous and
are quite significant for cross-border business,
especially when considering that in 2007 aggregate
cross-border investment amounted to more than $140 billion
and cross-border income flows have generally exceeded $30
billion a year since 1995 (Joint Committee on Taxation,
Explanation of Proposed Protocol to the Income Tax
Treaty Between the United States and Canada 20
(JCX-57-08) (July 8, 2008)). With so much cross-border
income flow, the importance of the protocol in further
reducing the potential for double taxation and providing
an incentive for trade is enormous.

This item
focuses on protocol provisions that significantly affect
cross-border business, namely the elimination of
withholding taxes on cross-border interest payments, the
lookthrough provision for dividends, and the treatment of
LLCs and other hybrid entities.

Before diving into
some of the provisions, some attention must be paid to the
process that will put the new protocol into effect. The
signed protocol will not enter into force until both the
United States and Canada have separately ratified it
through their internal governmental processes and the
instruments of ratification have been exchanged. In
Canada, the ratification process has already been
completed (An Act to Amend the Canada-United States Tax
Convention Act, 1984, 2007 S.C., ch. 32). In the United
States, the protocol went through a hearing in the Senate
Committee on Foreign Relations in July and was forwarded
to the U.S. Senate for approval but was not considered
before the Senate’s summer recess. Although there is much
interest in the ratification of the protocol and its entry
into force before the end of 2008, especially in light of
some of the provisions discussed here, there is no
certainty that the Senate will be able to do so before
December 31, 2008.

Elimination of Withholding Tax
on Interest

The elimination of withholding tax on
cross-border interest payments is one of the most
significant provisions in the protocol and likely the one
that will affect the most taxpayers in both countries. In
most cases, Article XI of the current treaty provides for a
10% withholding tax rate for interest paid across the
border. Article 6 of the protocol will modify Article XI so
as to retroactively reduce that rate to zero for interest
payments to unrelated parties as of January 1 of the year
the protocol enters into force and will begin phasing out
the interest on related-party interest over a period of
three years. This phaseout will reduce the withholding rates
to 7% (also retroactively) for the first year the protocol
enters into force, then reduce it to 4% and zero in the two
subsequent years. One exception is for contingent interest,
as defined in Sec. 871(h)(4), which will be subject to a 15%
withholding rate.

The lack of certainty
with respect to the protocol’s ratification and its entry
into force is creating planning issues for taxpayers on
both sides of the border. Because the current treaty
provides for the 10% withholding rate on interest
payments, taxpayers have been collecting those amounts and
remitting them to the tax authorities. Should the protocol
be ratified in 2008, it will provide a retroactive
reduction in the rates (0% for unrelated parties and 7%
for related parties) that may translate into significant
tax refunds for taxpayers. Although no mechanisms are
explicitly suggested in the protocol for dealing with such
refunds, experiences with similar provisions in past
protocols suggest that taxpayers may need to file actual
tax returns with the other country’s authorities to claim
a refund of the overwithholding based on the new protocol
provisions.

Dividends Lookthrough Provision

Dividend withholding rates under the protocol, unlike
interest withholding and dividend withholding rates in the
latest U.S. treaties, will not be eliminated, reduced, or
gradually phased out. However, the lookthrough provision
contained in Article 5 of the protocol (modifying Article X
of the treaty) will make the reduced 5% withholding rate
available to corporate taxpayers who indirectly own
corporations in either country where those shareholders
would not have been able to do so before. Exhibit 1
illustrates situations in which the 5% withholding rate
would apply.

Example 1 in the exhibit may be the cost
common: A Canadian corporation (CanCo) is indirectly owned
by a U.S. corporation (USCo) through an entity that is
considered fiscally transparent under U.S. tax laws (US).
In this case, USCo will be able to benefit from the 5%
withholding rate as long as it owns at least 10% of the
stock in CanCo through US.

Example 2 provides an
alternative scenario in which shares in USCo are
indirectly held by CanCo through its ownership in a
partnership in a third country (3d Co LP). Since 3d Co LP
is considered a fiscally transparent entity under tax laws
in Canada (where beneficial owner CanCo resides), the 5%
reduced withholding rate would apply to dividends paid by
USCo to 3d Co LP. This remains true even when in the
United States a check-the-box election was made to treat
3d Co LP as a corporation.

In Example 3, the
situation is reversed and the dividends paid by CanCo to
3d Co LP do not qualify for the 5% reduced withholding
rate. Since 3d Co LP has checked the box to be treated as
a corporation under U.S. tax laws (where beneficial owner
USCo resides), it is not considered a fiscally transparent
entity in the United States and therefore the lookthrough
provision does not apply.

One curious result of
this lookthrough provision under the protocol is that it
effectively requires the dividend-paying corporation to
become acquainted with the tax laws of its indirect
owners’ countries of residence to determine if under those
laws the intermediary entities would be treated as
fiscally transparent and therefore eligible for the
reduced withholding rate. This requirement to look into
the other country’s laws to determine if an entity is
considered to be fiscally transparent is also specifically
mentioned in Article 2 of the protocol, which modifies
Article IV of the treaty dealing with definitions of tax
residence under the treaty.

Fiscally Transparent
and Hybrid Entities

The issue of treaty benefits
applied to fiscally transparent and hybrid entities was a
major aspect of the protocol, and the results in some cases
will not be good for some U.S.-owned businesses in Canada
operating under the common check-the-box Canadian unlimited
liability company (ULC) structure. Under U.S. check-the-box
regulations, a U.S. taxpayer (USCo) would elect to treat the
Canadian ULC, normally formed under Nova Scotia or Alberta
laws, as a partnership for U.S. tax purposes. The result is
an entity, the ULC, that is a 100% owned partnership and so
is effectively disregarded for U.S. tax purposes but is
still treated as a corporation for Canadian tax purposes
(see Exhibit 2).

The provision contained in
Article 2 of the protocol (modifying Article IV of the
treaty, on residence) determines that in such a case, USCo
would not be eligible for benefits under the treaty. USCo
would thus be subject to the full Canadian withholding tax
rate of 25% on payments (i.e., dividends, interest, rents,
royalties) it receives from the ULC. Since the ULC is
disregarded for U.S. tax purposes, the payments from it to
USCo are also disregarded, and the payments would not
constitute foreign source income to USCo with which it
could claim the Canadian withholding tax as a foreign tax
credit to reduce its U.S. taxes.

Although the
operating income generated by the ULC would provide
foreignsource income for the year in which the withholding
taxes would be assessed and so potentially would allow for
the use of the foreign tax credit, a possible mismatch of
the amount of foreign-source income and foreign taxes
could result due to timing differences in the recognition
of the withholding taxes and distributions made.

The good news is that the provisions in the protocol
dealing with the disallowance of benefits under the treaty
for such structures will enter into force at the earliest
in 2010, provided that the protocol is ratified before the
end of 2008. This gives taxpayers some time to properly
plan to adjust their structures to reflect the new treaty
provisions.

Other Provisions

Other
significant provisions in the protocol not discussed here
include a reduced U.S. withholding rate on dividends
received by companies from real estate investment trusts in
some cases, the elimination of withholding tax on
cross-border guarantee fees, the requirement for mandatory
arbitration, the extension of limitation of benefits
provisions to apply to Canadian residents, changes to
pension and annuities withholding, changes to determination
of permanent establishment for personal services,
consequences to other structures involving fiscally
transparent and hybrid entities, and others. (For more on
the protocol, see Sardella, “Commentary on the Canada-U.S.
Tax Treaty’s Fifth Protocol,” 39 The Tax Adviser
150 (March 2008).)

The protocol will bring significant
changes to the treaty and require that companies from both
sides of the border seriously consider the effects of
these changes on their businesses. Some of the changes
will have an immediate impact, mostly positive, as soon as
the protocol enters into force. For some of the more
significant changes, which include some with potentially
harmful effects, the uncertainty as to the timing of the
protocol’s ratification by the U.S. Senate and the
phase-in of many of the significant changes provide a
window for companies and advisers alike to properly plan
for their impact. The key is to begin the process early.

EditorNotes

Kevin F.
Reilly, J.D., CPA, is a member of PKF Witt Mares in
Fairfax, VA.

Unless otherwise noted, contributors are members of or
associated with PKF North American Network.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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